Understanding Smart Beta

When it comes to investing, it can seem like there are as many strategies as there are investors. Some seek outsized returns; others aim for more modest goals in the interest of mitigating risk.

Smart beta funds have become a popular option for those looking to strike a balance between the low-cost efficiency of traditional index funds and the pursuit of higher returns through active management. But what’s smart beta really all about?

What Exactly Is Smart Beta?

Smart beta funds take the middle ground between traditional passive investing (tracking a market index like, say, the S&P 500) and active investing, where fund managers choose stocks in an attempt to outperform the market.

Smart beta focuses on the drivers of risk and return.¹ While traditional index funds weight stocks based purely on their market capitalization, smart beta funds employ alternative weighting strategies based on specific “factors”² such as value, growth, dividends, momentum, or volatility.

What’s Beta Got to Do with It?

Beta measures the sensitivity of an asset’s return to the overall market return, or how much a stock price fluctuates in comparison to the overall market.

If we really want to understand how smart beta works, we should take a look at the Capital Asset Pricing Model (CAPM).³ Simply put, the CAPM stated that one factor, the market, drives return as expressed through beta.

Further academic research in quantitative finance⁴ identified three factors that drive returns: market risk; the outperformance of small-cap companies relative to large-cap companies; and the outperformance of high book-to-market value companies versus low book-to-market value companies.

A Variety of Factors

Since the first three factors were identified in the early 90s, additional factors have been determined to drive returns. The most commonly used factors today include:

• Value: Value stocks appear to be undervalued relative to peers based on metrics such as the price-to-earnings ratio or book value compared to intrinsic value.
• Size: This is based on the idea that smaller companies have greater potential for growth.
• Momentum: This assumes that stocks which have recently exhibited strong appreciation will continue their upward trajectory.
• Quality: Companies with strong financials including high profitability, low debt, and consistent earnings growth should be expected to outperform. 
• Low Volatility: Seeks to minimize risk by focusing on stocks with lower price wings, assuming they are safer bets during downturns. 
• Equal weighting: Instead of weighting stocks by market cap, allowing the largest companies to dominate, this strategy gives each stock the same importance and should improve diversification.

What’s Smart Beta All About?

Bridging the gap between active and passive investing: Traditional index funds are popular because they’re simple and inexpensive. However, they may not always deliver the best returns. Actively managed funds seek outperformance but often come with higher fees and volatility. 

We believe smart beta is the compromise, offering a structured, rules-based approach like an index fund but with the potential to outperform the market. 

Enhanced diversification: A market-cap weighted fund can see diversification eroded when the largest companies dominate. An S&P 500 fund, for example, can see behemoths like Apple or Microsoft* comprise a significant portion of the portfolio, leaving investors vulnerable if they do poorly.

A smart beta fund employing factors such as equal weighting or small cap can reduce concentration risk and provide more exposure across different stocks or sectors.

Customization: With smart beta funds, investors can align their portfolios with their own specific goals. If risk is an issue, a fund that strives for low volatility could be a good choice. Investors looking for income might opt for a high-dividend strategy. Tailoring portfolios to specific factors may help achieve better alignment with financial objectives.

Cost efficiency: Although more expensive than traditional index funds, smart beta funds still have lower fees than many actively managed funds. 

How Smart Beta Works

While the methodology can be complex, the idea underlying smart beta is simple. These funds track customized indexes with their own set of rules designed to emphasize certain characteristics.

• Choose the factors. For example, a fund focused on low volatility might include only stocks that historically have not experienced dramatic swings in price.
• Build the portfolio. Once the factors are chosen, the fund uses a rules-based framework to select and weight component stocks. A quantitative model, rather than a fund manager, drives portfolio construction.

• Rebalance periodically: Over time, market conditions change, and some stocks may no longer meet the criteria. Smart beta funds typically rebalance regularly to ensure adherence to their strategy.

• Use custom indexes: Smart beta funds typically track their own bespoke indexes designed around their specific rules.

The Benefits of Smart Beta

Smart beta funds can offer several advantages:

• Performance: By targeting specific factors, these funds can seek to outperform traditional indexes over the long term.
• Lower cost: While more expensive than regular index funds, smart beta funds typically have lower fees than actively managed funds. 
• Risk mitigation: Factors such as low-volatility or equal-weighting may help improve diversification.
• Transparency: Because these funds follow rules-based methodology, investors should know exactly what the underlying strategy is and how the fund selects stocks. 

Smart Beta Funds Have Risks As Well

No investment comes without risk. Understanding the risks that accompany smart beta is necessary to make an informed decision.

• Reliance on past performance: Many smart beta strategies are based on a historical analysis of markets. Past performance is no guarantee of future results. 
• Higher fees: These funds, while typically less expensive than actively managed products, still have higher expense ratios than index funds, and these fees can eat into returns over time.
• Complexity: There can be a steep learning curve in understanding how these funds work, and which factors will most closely align with your investment goals. A lack of understanding can lead to poor fund selection.
• Market Cyclicality: Some factors can underperform in specific market environments. For example, a value strategy may underperform during a growth stock rally. 
• Less Diversification in Some Cases: Funds narrowly targeting certain sectors or factors may lack the broad diversification of traditional index funds.

Introducing TMFE

Motley Fool Asset Management has developed a smart beta option, the Motley Fool Capital Efficiency 100 Index ETF (TMFE) that uses capital efficiency, or the measure of how much a company spends on growing revenue compared to profits.

Companies are ranked by The Motley Fool, LLC analysts using a capital efficiency score that ranks them based on their historical ability to transform investment into consistent profits and stable growth. The score is based on measures of profitability, growth, and stability.

The index created using this ranking seeks to augment return by choosing what The Motley Fool, LLC analysts determine are high performing companies while striving to mitigate and risk and volatility by capping positions sizes at the quarterly reconstitution at 4.8%—avoiding the concentration that comes with a simple market cap weighted index.

The Takeaway

Smart beta funds can offer investors new opportunities, providing customization and potentially enhanced risk-adjusted results.  That said, they aren’t without their challenges.

Understanding your investment goals, risk tolerance, and the specific factors driving a smart beta strategy are the essentials in making an informed decision. Whether you want higher returns, less risk, or more diversification, smart beta funds can be a valuable tool in seeking to achieve your financial objectives.